new issues puzzle - university of california, riversidefaculty.ucr.edu/~abarinov/10 new issues...

New Issues Puzzle

Professor Alexander Barinov

Terry College of BusinessUniversity of Georgia

FINA 4330 Trading Strategies

Alexander Barinov (Terry College) New Issues Puzzle FINA 4330 Trading Strategies 1 / 44

Outline

1 Issuing Process

2 New Issues Puzzle and the Like

3 Rational StoriesFirm-Type StoriesRisk-Shift Stories

4 Behavioral Stories

5 Is New Issues Puzzle Real?


Issuing Process

How to Issue StockIf a firm goes public, it has to register the issue withSEC and incur registration and disclosure costs

The firm sells all stocks to the underwriter and theunderwriter sells them to investors in the primarymarket

The lead underwriter can team up with otherunderwriters and may or may not offer theguarantee that the whole issue will be sold

The buyers submit the prices and the amount theywant to buy, the highest bids get the shares

If the issue is oversubscribed, the winning bidsmay be prorated


Issuing Process

Types of Issuing

Initial Public Offering (IPO) - when the companygoes public

Usually, a large fraction (70-80%) of thecompany remains privately held

Seasoned Equity Offering (SEO) - often one ortwo years after the IPO more shares are issued,the management may sell some shares as well

Shelf issue - shares registered, but not soldduring IPO/SEO

Mixed SEOs - both stocks and bonds are issuedAlexander Barinov (Terry College) New Issues Puzzle FINA 4330 Trading Strategies 4 / 44

Issuing Process

IPO UnderpricingThe biggest cost of the IPO is the underpricing of theshares at the issue date

On average, the stock price increases by 20% on thefirst trading day

It is true for all countries we have data on

You have to underprice to make sure informedinvestors tell you that the stock is good (Benvenisteand Spindt, JFE 1989)

You have to underprice to save uninformed investorsfrom the winner’s curse (Rock, JFE 1986)

Only large clients of underwriters are able to profitfrom the underpricing


Issuing Process

SEO Announcement Effect

When the firm announces the SEO, the sharesdrop by about 2%

Is it the cost of SEO - probably not, it is theimpact of information

There is some evidence that investors expectthe misuse of the raised funds - theannouncement effect is smaller for growth firmsand during expansions

There is also SEO underpricing (about 3% ofthe price at the issue date)


New Issues Puzzle and the Like

New Issues Puzzle: Ritter (JF 1991),Loughran and Ritter (JF 1995)

On average, new issues underperform by 5-6% peryear for 3-5 years

First 6 months - "honeymoon period" (nounderperformance)

New issues by small firms underperform more

HML factor helps somewhat, because growth firms(less risky) tend to issue more

Behavioral story: firms waste part of the raisedmoney, but investors do not foresee it



Continuation or Reversal?All anomalies can be divided in continuation anomalies andreversal anomalies

Value effect is a reversal anomaly: investors becomeoveroptimistic about growth firms, then bad performancefollows

Momentum is a continuation anomaly: investors cannot digestall good news about winners, thus winners continue winningfor a while

IPO underpricing suggests that long-run underperformance ofIPOs is reversal: investors become too excited when the newcompany hits the market

Negative announcement effect for SEOs suggests thatlong-run underperformance of SEOs may be continuation, butdo not forget that SEOs follow very good performance



What Else Do We Know About theNew Issues Puzzle?

Debt issuance also means long-termunderperformance, especially if the debt isconvertible (Spiess and Affleck-Graves, JFE1999)

Spinoffs and carve-outs do not underperform(Vijh, JFE 1999)

Private placements also result in long-termunderperformance (Hertzel, Lemmom, Linck,Rees, JF 2002) - do owners of private firms alsosquander cash?



New Issues Puzzle, 1986-2006IPOs have high market betas, are like small firmsand probably like growth firms

IPOt − RFt = − 0.41(0.19)

+ 1.23(0.07)

·(MKTt − RFt)+

+ 1.05(0.14)

·SMBt − 0.21(0.16)

·HMLt

SEOs have high market betas, are like small firmsand are neither value nor growth

SEOt − RFt = − 0.42(0.13)

+ 1.20(0.055)

·(MKTt − RFt)+

+ 0.77(0.10)

·SMBt − 0.02(0.09)

·HMLt



Data Sources: IPOsOne of the best data sources on IPOs is theMSN IPO CenterYou should look for recent IPOs via the IPOPerformance tab, not IPO filings, because moreoften than not a company files with SEC forpermission to do an IPO, but never actuallydoes it, or does it years laterOther valuable sources of information: JayRitter’s website and EDGAR database at SECA lot of data on IPOs either do not exist or arenot public (yet) - like returns, financials, analystcoverage, etc.



Data Sources: SEOsSEOs data are hard to get, but you can try ThompsonOne while you are at UGA

You can use the knowledge that SEOs usually come onthe heels of IPOs and comb through Form S-1A filings inEDGAR

According to Daniel and Titman (JF 2006), SEOunderperformance is not limited to only large issues -whenever the firm issues, even in small amounts andeven not for raising capital, the underperformance is likelyto follow

Suggestion: compare the current market cap to themarket cap without issuing, i.e., the product of the marketcap 5 years ago and cumulative return during the 5 years


Rational Stories

Two Pieces of a Rational StoryWe need to explain two things about the newissues puzzle: why it exists and why it lasts onlyfor three years

Firm-type stories: new issues are performed bysome type of firms we cannot yet price right (butwhat happens after three years?)

Risk-shift stories: issuing stock makes the firmless risky (why then we see a negativeannouncement effect for SEOs?)

We need both stories or at least a strongrisk-shift story


Rational Stories Firm-Type Stories

New Issues, Size and MB:Brav et al (JFE 2000)

Performance of new issues is no different from theperformance of similar firms (similar means samesize and market-to-book)

Recall from previous lectures that we cannotexplain the returns to the smallest growth firms

For example, the underperformance of smallgrowth stocks was the driving force behind themuch stronger value effect for small firms

Firm-type story: stock just happens to be issued bysmall growth firms we do not know how to price



Small Growth Puzzle:VW CAPM Alphas for Size-MB Sorts

Small Size2 Size3 Size4 Big S-BGrowth -1.009 -0.559 -0.397 -0.068 0.007 -1.016t-stat -2.93 -2.52 -1.98 -0.37 0.05 -2.64BM2 0.063 -0.063 0.075 0.156 0.171 -0.108t-stat 0.22 -0.29 0.41 0.82 1.30 -0.32BM3 0.287 0.384 0.203 0.249 0.171 0.116t-stat 1.20 1.74 0.97 1.12 1.12 0.42BM4 0.571 0.418 0.343 0.437 0.276 0.295t-stat 2.25 1.88 1.44 2.06 1.37 0.99Value 0.550 0.302 0.483 0.375 0.253 0.298t-stat 1.98 1.14 1.82 1.59 1.03 0.89V-G 1.560 0.861 0.880 0.443 0.246 1.313t(V-G) 4.57 2.66 2.36 1.29 0.80 4.05



New Issues, Size and MB:Brav et al (JFE 2000)

Brav et al (JFE 2000) sort firms five-by-five on sizeand market-to-book and see where new issues fall

If new issues were falling randomly, only 4% (100/25)would fall in the group with the highest market-to-bookand the lowest market cap (the small growth group)

In the data, though, 51.8% of IPOs and 24.1% ofSEOs fall into the small growth group

Brav et al. - "there should be a common factor behindthe new issues puzzle and the small growth anomaly"



IPOs, Size and MB:Brav et al (JFE 2000)

Sort firms on size and MB using NYSE breakpoints

IPOs are exclusively small growth firms (51.8%instead of 4% fall into the smallest growth group)



SEOs, Size and MB:Brav et al (JFE 2000)

SEOs are usually small growth firms (24.1%instead of 4% fall into the smallest growth group)



Practical Advice from Brav et al.New issues are just small growth firms - if youcannot find them or short them, just short somesmall growth firms

Likewise, if you cannot find data on IPOs beta orliquidity (on average), you can look at small growthfirms for a benchmark

Also, one may suspect that if IPOs and SEOs havenegative alphas because they are small growthfirms, IPOs and SEOs will underperform only iftheir market cap is low and their P/E ratio is high

This is exactly what we see in the data



Investment FactorLyandres, Sun, and Zhang (RFS 2008) use theinvestment factor to explain the new issuespuzzleMain story: firms invest a lot when required rateof return is low, i.e. their projects have low riskIf they need to invest, they have to raise cashHence, the firms with lowest risk self-select intothe issuing sample (firm-type story)The story is agnostic on why investment isrelated to returns, but think about the investmentstory for the value effect



Forming the Investment Factor

First, sort firms into three bins on size and intothree bins market-to-book (top 30%, middle40%, bottom 30%)

Then, in each bin sort firms on investment thesame way and go long in low investment firmsand short in high investment firms

Take value-weighted returns and then averageacross the nine size and market-to-book bins

The investment factor earns about 6% premium,unexplained by the CAPM and the FF model



Measuring Investment

Investment - CAPEX plus change in workingcapital divided by total assets

CAPEX - what you spend on buying equipmentWorking capital - what you need to run business, likeinventory and customers debtWorking capital grows as the firm grows, but it mayalso grow if you cannot sell anything or cannotcollect debts

Working capital can either mean validinvestment, or indicate that the managersquanders the raised cash



Investment Factor: Conclusions

IPOt − RFt = − 0.58(0.29)

+ 1.47(0.09)

·(MKTt − RFt)

IPOt − RFt = − 0.09(0.36)

+ 1.30(0.09)

·(MKTt − RFt)− 0.79(0.34)

·INVt

Investment factor wipes away the new issues puzzle - itreduces alphas by 80% and makes them insignificant

If investment is measured without investment in workingcapital, the reduction in the alphas is 40% and some aresignificant (see an earlier version of the paper)

Main conclusion: new issues underperform becausethey are like highest investment firms, which alsounderperform



Investment Factor andOverinvestment

A behavioral story about why high-investment firms havelow returns going forward is that these firms overinvest (inunprofitable projects), but investors are slow to realize that

OK, new issues are like high-investment firms: do theyoverinvest as well?

Investment factor works worse without the working capital- hints that the squandered cash can be important inexplaining the new issues puzzle

NB: If we drop January 2001, when IPOs earned 39%and SEOs earned 24%, the investment factor explainsonly 50% of the alphas and some are significant



Practical Advice from Lyandres et al.

We learned about the investment effect -low-investment firms beat high-investment firms

You can just sort firms on CAPEX-to-assetsinstead of hunting for IPOs/SEOs and makesimilar profit

Also, if IPOs and SEOs underperform becausethey are high-investment firms, one can suspectthat the new issues puzzle will be strong only forthe firms that invest a lot



Volatility Risk Story

IPOs and SEOs are small growth stocks

Growth options beat the CAPM in recessions,because they benefit from higher volatility

This effect is naturally stronger for the firms withhigh volatility, which are usually small

We have a firm-type story: IPOs and SEOs havelow returns, because they are small growthfirms, and small growth firms have low returnsbecause they beat the CAPM when marketvolatility increases



Volatility Risk Story

IPOt − RFt = 0.09(0.32)

+ 2.27(0.11)

·(MKTt − RFt) + 1.185(0.12)

·FVIXt

Volatility risk factor (FVIX) explains why smallgrowth firms have low returns (which waspuzzling for CAPM and Fama-French model)

Volatility risk factor also solves IPOs and SEOs

Even better, consistent with the story, FVIXexplains why small new issues and growth newissues underperform and why large new issuesand value new issues do not underperform


Rational Stories Risk-Shift Stories

New Issues Puzzle and Default Risk

Eckbo, Masulis, and Norli (JFE 2000) try toexplain the new issues puzzle by anICAPM-type model

When firm issues equity, it lowers leverage andbecomes less likely to default, i.e. less risky

We can use a factor based on default spreadand expect negative loadings on it for newissues

Problem: in cross-section, leverage and defaultprobability are negatively related to future returns(see, e.g., Dichev, JF 1998)



New Issues Puzzle and Inflation RiskIf inflation unexpectedly goes down, debtholderswin and shareholders suffer

If leverage is low, losses from deflation arerelatively smaller and the correlation of returns andunexpected inflation is less positive

Positive correlation between returns andunexpected inflation is bad, because unexpecteddeflation means unexpected recession

So, we expect negative loading of new issues onthe factor-mimicking portfolio that is positivelycorrelated with unexpected inflation



ICAPM Regression for SEOs

SEOs go up when default risks are high andalso go up when inflation is low

Both things happen in recession, so SEOs giveus additional consumption during recessions

This is why we tolerate low returns to SEOs

The macro variables explain the SEOunderperformance in all event periods

The decline in underperformance is still visible -do we really have a good risk-shift story?



New Issues and Turnover

Eckbo and Norli (JCF 2005) argue that issuingstocks creates additional float and turnover, andtherefore makes the stock more liquid and lessrisky

Low minus high turnover factor explains theperformance of IPOs and SEOs

The explanation from the turnover factor of whythe new issues puzzle lasts for only three yearsis less convincing, because issuing stock stopscreating higher turnover after two years



New Issues and Turnover

Also, high turnover, contrary to expectations,does not mean that the stock is easier to unloadduring bad times

Finally, the turnover factor ascribes the lowestlevel of liquidity risk to small new issues andgrowth new issues, which explains why thosehave the most negative CAPM alphas, but doesnot make any economic sense

We will see later that it is possible that turnoverproxies for uncertainty, and the turnover factortherefore stands for FVIX


Behavioral Stories

Basic Behavioral StoryFree cash flow story (Jensen, AER 1986): if the firm hasthe cash, part of it will be wasted on pet projects andprivate jets

New issues puzzle arises because investorsunderestimate the scope of the free cash flow problemand are unpleasantly surprised by the future performanceof new issues

New issues puzzle was initially documented in bothreturns and operating results

After the issue, issuers have low profitability, even thoughthey invest a lot

Rational answer: could it just be that their required rate ofreturn (and risk) is low?


Behavioral Stories

Related PuzzlesJensen (AER 1986) suggests debt and highdividend payments as a treatment of the freecash flow problemManagers have to make interest and dividendpayments and have less slack compared towhen they use internal cash flows or equityWe still see slight underperformance after debtissues (the manager can still lay hands on theextra cash), but it is within 2% per yearConvertible debt issuers see largerunderperformance (3-4% per year), but lessthan equity issuers


Behavioral Stories

New Issues Puzzle in Cross-Section

New issues puzzle is stronger for small firmsand growth firms

Seems contrary to the behavioral story: thesefirms do not have much to waste and theirsecond-choice projects are still quite good

Yet we can put some behavioral twist on it: smallfirms are hard to trade, growth firms may beoverpriced and managers know it


Behavioral Stories

Opportunistic Issuance

This is the second behavioral story for the newissues puzzle: managers know when their stockis overpriced and issue only if it is

Investors subsequently learn that they paid toomuch for the stock, and the stock post badreturns

While it is not surprising that managers are moreinformed than simple investors, investors mustbe irrational to fall for this trick (issuing equityonly if it is overvalued) over and over again


Behavioral Stories

New Issues andEarnings Management

New issues puzzle is stronger for the firms that managetheir earnings (Rangan, JFE 1998, Teoh, Welch, andWong, JFE 1998)

Earnings management is defined as the cases when thedifference between earnings and cash flows is too largegiven the nature of the business

Earnings and cash flows have to be different (see, e.g.,depreciation), but managers sometimes fudge in funnystuff

Conclusion: Investors can be cheated into believing thatthe firm is better and more prosperous than it actually is


Is New Issues Puzzle Real?

IPO WavesIPOs happen in waves: one year, many companies gopublic, several years after nobody goes public

Similar, though weaker picture, is observed for SEOs

Waves feed many behavioral theories, becauseunderperformance is stronger after hot markets(Lowry, JFE 2003)

Waves may be the consequence of overexcitement,and everything in the hot market is overbought

Waves may be the windows of opportunity for themanagers to issue overpriced equity, which has to fallafterwards



Calendar-Time and Event-TimeSuppose in a cold market 5 firms issue stock andearn the CAPM alpha of -3% each

Then in a hot market next year 20 firms go publicand earn the CAPM alpha of -9% each

We could commit $1000 to IPOs in each period -then our alpha is -6% on average across the twoperiods

This is the calendar-time approach - weight allperiods equally

But nobody does that - hot markets are notpossible if everyone invests the same amount innew issues all the time



Calendar-Time and Event-TimeWe can commit $100 to each new issue we see

Then our alpha in the example above is

5 · $100 · (−3%) + 20 · $100 · (−9%)

5 · $100 + 20 · $100= −7.8%

This the event-time approach: each stock is weightedequally

When we estimate CAPM or Fama-French model, wetake the calendar-time approach

Loughran and Ritter (JFE 2000): event-time weighting isthe way to go

In event time, new issues puzzle is 12-15% per year, not5-6% per year



Pseudo Market TimingSchultz (JF 2003): event-time results can bespurious

Suppose that for some reason managers like toissue stock after it has gone upThen we will see stronger underperformanceafter hot markets: we just call markets hot afterthey slowed down after the price drop

Example: Suppose this year 100 companies will gopublic. If next year is bad, then less companies willgo public next year and we will call this year hotmarket. If next year is good, even more companieswill go public, and this year will not count as a hotyear



Pseudo Market Timing

Consequence: after several good years, morenew issues are caught in a slide

After several bad years, though, new issues arescarce and nobody participates in the rebound

Even if managers like high prices just becausethey are high, having no information aboutoverpricing, we can see new issuesunderperformance in event-time and nounderperformance in calendar-time

Hence, use CAPM and Fama-French models



OK, So Who Is Right?If you ask "how bad is a random IPO?" (because youconsider investing in only one IPO) - then the CAPMalphas are the answer

That is, first form portfolios out of all recent IPOs withineach month, then estimate the alpha

If you ask "how smart is it to run with the crowd and investin IPOs more when the IPO market becomes hot?" - thenthe event-time approach has the answer

That is, first measure the alpha for each individual stock,and then average (thus giving more weight to hotmarkets, when there are more IPOs)

Running with the crowd is way worse than just buying oneIPO (-6% per year vs. -15% per year)



Recap: New Issues PuzzleFirms underperform by 5% per year for 3-5years after they issue stockProbably stock is being issued by the type offirms we do not fully understand (small growthfirms, high investment firms)New issues beat the CAPM when marketvolatility increases - they are less risky thanwhat their market betas implyProbably issuing stock protects from deflationrisk and default risk and creates more liquidity,but we still do not quite understand why the newissues puzzle stops after 3 years


new issues puzzle - university of california, riversidefaculty.ucr.edu/~abarinov/10 new issues...

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